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Foreign Exchange Derivative Market. 16. Chapter Objectives. Explain how various factors affect exchange rates Describe how foreign exchange risk can be hedged with foreign exchange derivatives

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Foreign Exchange




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Chapter Objectives

  • Explain how various factors affect exchange rates

  • Describe how foreign exchange risk can be hedged with foreign exchange derivatives

  • Describe how to use foreign exchange derivatives to capitalize (speculate) on expected exchange rate movements

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Background On Foreign Exchange Markets

  • Exchanging currencies is needed when:

    • Trade (real) prompts need for forex

    • Capital flows (financial) prompts need for forex

  • Foreign exchange trading

    • Via global telecommunications network between mostly large banks

    • Bid/ask spread

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Foreign Exchange Rates

  • Quoted two ways:

    • Foreign currency per U.S. dollar

    • Dollar cost of unit of foreign exchange

  • Appreciation/depreciation of currency

    • Appreciation = more forex to buy $

    • Purchase more forex with $

    • Depreciation = foreign goods cost more $

    • Total return to foreign investor decreases

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Background on Foreign Exchange Markets

  • Exchange rate quotations are available in the financial press and on the Internet with spot exchange rate quotes for immediate delivery

  • Forward exchange rate is for delivery at some specified future point in time

  • Forward premium is the percent annualized appreciation of a currency

  • Forward discount is the percent annualized depreciation of a currency

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Background on Foreign Exchange Markets

  • Exchange rates involve different kinds of quotes for comparing the value of the U.S. dollar to various foreign currencies

    • 1 unit of foreign currency worth some amount of U.S. dollars—e.g. $.70 U.S. per Canadian Dollar

    • 1 U.S. dollar’s value in terms of some amount of foreign currency– e.g. CD$1.43 per U.S. dollar

    • Note reciprocal relationship

  • Cross-exchange rates express relative values of two different foreign currencies per $1 U.S.

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Background on Foreign Exchange Markets

  • Cross-exchange rates are foreign exchange rates of two currencies relative to a currency.

  • Value of one unit of currency A in units of currency B = value of currency A in $ divided by value of currency B in $

  • British Pound = $1.4555; Euro = $.8983

  • Value of Pound in Euros = $1.4555/$.8983 or…

    • 1.62 Pounds per Euro using the forex rates per U.S. dollar

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Background on Foreign Exchange Markets

  • Currency terminology

    • Appreciation means a currency’s value increases relative to another currency

    • Depreciation means a currency’s value decreases relative to another currency

  • Supply and demand influences the values of currencies

  • Many factors can simultaneously affect supply and demand

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Background on Foreign Exchange Markets

  • 1944–1971 known as the Bretton Woods Era

    • Government maintained exchange rates within a 1% range

    • Required government intervention and control

  • By 1971 the U.S. dollar was clearly overvalued

Background on Foreign Exchange Markets

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Background on Foreign Exchange Markets

  • Smithsonian Agreement (1971) among major countries allowed dollar devaluation and widened boundaries around set values for each currency

  • No formal agreements since 1973 to fix exchange rates for major currencies

    • Freely floating exchange rates involve values set by the market without government intervention

    • Dirty float involves some government intervention

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Classification of Exchange Rate Arrangement

  • There is a wide variation in how countries approach managing or influencing their currency’s value

    • Float with periodic intervention

    • Pegged to the dollar or some kind of composite

    • Some countries have both controlled and floating rates

    • Some arrangements are temporary and others more permanent

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Factors Affecting Exchange Rates: Real Sector

  • Differential country inflation rates affect the exchange rate for euros and dollars if inflation is suddenly higher in Europe

  • Theory of Purchasing Power Parity suggests the exchange rate will change to reflect the inflation differential—influence from real sector of economy

  • Currency of the higher inflation country (euro) depreciates compared to the lower inflation country ($)

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Factors Affecting Exchange Rates: Financial Sector

  • Differential interest rates affect exchange rates by influencing capital flows between countries

  • For example, the interest rates are suddenly higher in the United States than in Europe

  • Investors want to buy dollar-denominated securities and sell European securities

  • Euros are sold, dollars bought to buy U.S. securities

  • Downward pressure on the euro, appreciation of the dollar

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Factors Affecting Exchange Rates

  • Direct intervention occurs when a country’s central bank buys/sells currency reserves

  • For example, the U.S. central bank, the Federal Reserve sells one currency and buys another

    • Sale by central bank creates excess supply and that currency’s value drops relative to the one purchased

    • Market forces of supply and demand can overwhelm the intervention

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Factors Affecting Exchange Rates

  • Indirect intervention involves influencing the factors that affect exchange rates rather than central bank purchases or sales of currencies

  • Interest rates, money supply and inflationary expectations affect exchange rates

  • Historical perspective on indirect intervention

    • Peso crisis in 1994

    • Asian crisis in 1997

    • Russian crisis in 1998

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Factors Affecting Exchange Rates

  • Some countries use foreign exchange controls as a form of indirect intervention to maintain their exchange rates

  • Place restrictions on the exchange of currency

  • May change based on market pressures on the currency

  • Venezuela in mid-1990s illustrates the issues involved in controlling rates via intervention and the affect of market forces

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Movements in Exchange Rates

  • Foreign exchange rate changes can have an important effect on the performance of multinational firms and economic conditions

  • Many market participants forecast rates

    • Market participants take positions in derivatives based on their expectations of future rates

    • Speculators attempt to anticipate the direction of exchange rates

  • There are several forecasting techniques

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Forecasting Techniques



Technical Forecasting

Fundamental Forecasting

Mixed Forecasting

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Forecasting Exchange Rates: Technical

  • Technical forecasting is a technique that uses historical exchange rate data to predict the future

  • Uses statistics and develops rules about the price patterns—depends on orderly cycles

  • If price movements are random, this method won’t work

  • Models may work well some of the time and not work other times

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Forecasting Exchange Rates: Fundamental

  • Fundamental forecasting is based on fundamental relationships between economic variables and exchange rates

  • May be statistical and based on quantitative models or be based on subjective judgement

  • Regression used to forecast if values of influential factors have a lagged impact

  • Not all factors are known and some have an instant impact so sensitivity analysis is used to deal with uncertainty

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Forecasting Exchange Rates: Fundamental

  • Limitation of fundamental forecasting methods:

    • Some factors that are important to determining exchange rates are not easily quantifiable

    • Random events can and do affect exchange rates

    • Predictor models may not account for these unexpected events

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Forecasting Exchange Rates: Market-Based

  • Market-based forecasting uses market indicators like the spot and forward rates to develop a forecast

  • Spot rate: recognizes the current value of the spot rate as based on expectations of currency’s value in the near future

  • Forward rate: used as the best estimate of the future spot rate based on the expectations of market participants

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Forecasting Exchange Rates: Mixed

  • Mixed forecasting is used because no one method has been found superior to another

  • Multinational corporations use a combination of methods

  • Assign a weight to each technique and the forecast is a weighted average

  • Perhaps a weighted combination of technical, fundamental, and market-based forecasting

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Forecasting Exchange Rate Volatility

  • Market participants forecast not only exchange rates but also volatility

  • Volatility forecast

    • Recognizes how difficult it is to forecast the actual rate

    • Provides a range around the forecast

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Forecasting Exchange Rate Volatility

  • Volatility of historical data

  • Use a times series of volatility patterns in previous periods

  • Derive the exchange rate’s implied standard deviation from the currency option pricing model

Methods Used To Forecast Volatility

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Speculation in Foreign Exchange Markets

  • For example, a dealer takes a short position in a foreign currency to profit from expected depreciation

  • Dealer forecasts currency 1 to depreciate relative to foreign currency 2 so the first step is to borrow currency 1 and then exchange currency 1 for currency 2

    • Invest in currency 2 and receive the investment returns at maturity

    • Convert back to foreign currency 1 and pay back loan denominated in currency 1

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Foreign Exchange Derivative Contracts

Currency Swaps

Forward Contracts

Hedge or Speculate

Currency Futures

Currency Options

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Foreign Exchange Derivatives-Hedge

  • Forward contracts

    • Negotiated with a counterparty

    • Specify a maturity date, amount and which currency to buy or sell

    • Negotiated in over-the-counter market

    • Used to lock in the price paid or price received for a future currency transaction

    • Classic hedging contract

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Foreign Exchange Derivatives-Hedge

  • Forward contracts can be used to hedge if a corporation must pay a foreign currency invoice in the future

    • Purchase foreign currency for amount/date of invoice

    • Locks in cost of invoice

    • Hedges foreign exchange risk of transaction

  • Forward contracts are also used by hedgers who have a foreign currency inflow on some future date

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FR - S







Foreign Exchange Derivatives

  • Forward rate premium or discount


P = % annualized premium or discount

FR = Forward exchange rate

S = Spot exchange rate

n = number of days forward

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Foreign Exchange Derivatives-Hedge

  • Currency futures contracts trade on exchanges, are standardized in terms of the maturity and amount

  • Currency swaps allow one currency to be periodically swapped for another at a specified exchange rate

  • Currency options contracts offer one-way insurance to buy (call) or sell (put) a currency

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Foreign Exchange Derivatives-Hedge

  • Buying a call option on a foreign currency is the right to purchase a specified amount of currency at the strike price within the specified time period

    • Exercise the option if the spot rate rises above the strike price

    • Do not exercise if the spot rate does not reach or exceed the strike price

    • U.S. business that owes Canadian in 60 days buys currency call options to hedge spot forex risk

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Foreign Exchange Derivatives-Hedge

  • Buying a put option on a foreign currency is the right to sell a specified amount of currency at the strike price within the specified time period

    • Exercise the option if the spot rate falls below the strike price

    • Do not exercise if the spot rate does not decline below the strike price

    • U.S. business hedges Canadian dollar payment it will receive in 30 days by buying CD currency put options—if CD depreciates against U.S., gain will offset spot loss

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Foreign Exchange Derivatives-Speculate

  • Business or person has no spot interest in underlying asset—takes position based on forecast of currency movements

  • Forward contracts

    • Buy/sell foreign currency forward

    • When received, sell in the spot market

  • Purchase/sell futures contracts

  • Purchase call/put options

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Foreign Exchange Derivatives-Speculation

  • For example, what position in derivates would a speculator take if he/she anticipates a depreciation in a currency?

  • Forward contracts

    • Sell foreign currency forward

    • At maturity, buy in the spot market

  • Sell futures contracts

  • Purchase put options

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International Arbitrage

  • Arbitrage takes advantage of a temporary price difference in two locations to make profits buying at a lower price than you can receive via the simultaneous sale of an asset, financial instrument or currency

  • Risk free because the purchase and sale price are locked in simultaneously

  • As arbitrage occurs, prices in both locations change until equilibrium (one price) returns

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International Arbitrage

  • Covered interest arbitrage activity creates a relationships between spot rates, interest rates and forward rates

  • Borrow in country 1

  • Convert the funds to currency for country 2 using the spot rate; buy forward contract for return

  • Invest in country 2 and earn an investment rate of return

  • Convert back to country 1 currency using forward contract, repay loan

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International Arbitrage

  • Covered interest arbitrage activity makes forward premium approximately equal to the differential in interest rates between two countries

  • If forward premium does not equal the interest rate differential, covered interest arbitrage is possible

  • If the forward premium or discount equals the interest rate differential, there are no opportunities for arbitrage

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( 1 + ih)




(1 + if )

International Arbitrage

  • Equation for covered interest arbitrage


P = Forward premium or discount

ih = Home country interest rate

if = Foreign interest rate

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Explaining Price Movements of Foreign Exchange Derivatives

  • Indicators of foreign exchange derivatives are closely monitored by market participants

  • Hedgers and speculators continuously forecast direction and degree of movement and monitor

    • Inflation rates between countries

    • Interest rates

    • Economic indicators

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Foreign Exchange Markets

  • Exchanging Currencies Is Needed When:

    • Trade (real) prompts need For forex

    • Capital flows (financial) prompts need for forex

  • Foreign Exchange Trading

    • Via global telecommunications network between mostly large banks

    • Bid/ask spread

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Foreign Exchange Rates

  • Quoted Two Ways:

    • Foreign currency per U.S. Dollar

    • Dollar cost Of unit Of foreign exchange

  • Appreciation/Depreciation of Currency

    • Appreciation = more forex To buy $

    • Purchase more forex with $

    • Depreciation = foreign goods cost more $

    • Return To foreign investor decreases

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Exchange Rate Systems

  • Bretton Woods Era (1944-1971)

    • Fixed Or pegged forex rates

    • Central bank maintained rates

    • Could not adjust To major economic change

  • Smithsonian Agreement (1971)

    • Devalued dollar

    • Widened trading range Of forex

    • First Step Toward Market-Determined Forex

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Exchange Rate Systems

  • Market-Determined Rates (1973)

    • Dirty Float

    • Exchange Rate Mechanisms:

      • Currencies pegged to another

      • European currency unit (ECU)

      • Central Bank involvement

      • ERM problems

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Major Factors Affecting Forex

  • Differential inflation rates between countries

    • Goods and services impact demand/supply for foreign exchange

    • Inflating currency declines to provide….

    • Purchasing power parity

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Major Factors Affecting Forex

  • Differential interest rates between countries

    • Reflect expected differential inflation rates

    • Global Fisher Effect

  • Governmental Intervention

    • Domestic Economic Policy

    • Direct Intervention, e.g., Forex Controls

    • Market Forces Reign!!!

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Forecasting Foreign Exchange Rates

  • Technical forecasting

  • Fundamental forecasting

  • Market-based forecasting

  • Mixed forecasting

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Forecasting Forex Volatility

  • Forex prices difficult to forecast

  • Forecasting volatility creates range of probable forex rates

  • Use best- and worst-case scenarios in planning

    • Define future period

    • Consider historical volatility

    • Time series of previous volatility

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Speculation In Forex Market

  • Take position based on forex expectations

  • Expect To appreciate

    • Take long position (buy)

    • Forward contract to buy

    • Buy forex currency futures contract

    • Buy forex call options

  • Action taken if depreciation expected??

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Foreign Exchange Derivatives

  • Speculate vs. Hedging

  • Forward contracts

    • Contract To buy/sell forex at specified price on specified date

    • OTC market characteristics

    • Reflects expected future spot rate

    • Premium vs. Discount from spot

    • Interest rate parity concept

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Other Forex Derivatives

  • Currency futures contracts

  • Currency swaps

  • Currency option contracts

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International Arbitrage

  • Arbitrage defined

  • Locational arbitrage

  • Covered interest arbitrage

    • Maintains interest rate parity

    • Forward/spot differential =

      • Differential inflation rates

      • Interest rate differentials

      • Expected future spot rate

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Institutional Use Of Forex Market

  • Intermediary or dealer of forwards or other derivative contracts

  • Speculating/hedging

    • Future investment flows (loans, interest)

    • Future financing flows (principal and interest)